Magellan Midstream (MMP) has a nice safe distribution that should continue to gradually increase. However, a lack of growth projects and high valuation place the stock in the "Hold" category.
Company Profile
MMP is a midstream company focused on the transport, storage, and distribution of refined petroleum products, such as gasoline and diesel fuel. Approximately 71% of its business in refined products, while 29% is crude oil.
The company has the longest refined petroleum products pipeline system in the U.S. It consists of 9,800 miles with 54 terminals and has the capacity to store 47mm of refined products. The system primary carries gasoline and diesel fuel and can access nearly 50% of the refining capacity in the U.S.
Contracts are primarily fee based with about 85% of its operating margin coming from fee-based activities. Profits are driven by volume throughput on its system as well tariffs, which are tied to the PPI and other market factors.
Its Crude segment, meanwhile, consists of 2,200 miles of crude pipelines with 39mm barrels of storage. The pipelines are largely supported by take-or-pay contracts. The bulk of its storage capacity is around Houston and Cushing.
The company is structured as a master limited partnership (MLP).
Risk and Opportunities
MMP has historically been one of the most disciplined MLPs. It’s traditionally kept its leverage comparatively low and its coverage ratio high. As a result, when many midstream peers, such as Energy Transfer (ET) and Kinder Morgan (KMI), had to cut their distributions during the last energy bear market, not only did MMP maintain its distribution, it’s been able to consistently raise it every year.
While MMP has always been disciplined with its Capex, as shown by its strong return on invested capital, it has become particularly selective with growth projects the past two years. As such, it’s only spent growth capital of around $100 million each of the past two years, as new projects must be done at a 6-8x EBITDA multiple.
For a company with an ~$11 billion market cap, that’s a pretty low amount of growth Capex. It will look to bump that up to around $150 million this year, although that still isn’t much compared to where it was historically prior to Covid (typically $500 million or more) or for a midstream company its size.
On its Q4 earnings call, CEO Aaron Milford said:
"We currently expect to spend approximately $110 million in 2023 and $40 million in 2024 on expansion capital projects already underway. As you probably know, the largest project included in this spending profile related to the expansion of our refined products pipeline to El Paso, which as mentioned earlier, is expected to be operational in 2024. We continue to assess new opportunities to enhance Magellan's footprint and expect to find incremental projects that leverage the flexibility of our extensive network most likely around filling logistical gaps that may arise between market demand and available supply.
"You may recall that we've generally estimated around $100 million of expansion capital spending per year as a reasonable assumption for potential projects. As just noted, we're already planning to spend above that level for 2023. So depending on how successful we are and identifying near-term new projects, a number closer to $150 million as a reasonable placeholder for this year."
In terms of distribution growth, MMP is looking to increase its payout a modest 1% in 2023, similar to its increases in 2021 and 2022. Instead, management is much more focused of buying back shares, which it sees as the best use of its capital. On that end, the company is projecting 2023 FCF after distributions to be around $215 million. At the stock’s current prices, the company can buy back nearly 4 million in units, or about 2% of its units outstanding, if it only uses FCF after distributions to buy units. Last year, it bought back $472 million in units.
Commenting of its capital allocation plans, Milford said:
“It seems like adding materially to an already attractive distribution at spreads that are still to treasury is still wider than we think they should be and we compare doing that to the opportunity to buy back units. And when we compare the 2, which one of those do we think will create the most long-term value for our investors long term?
And as we sit here right now, we still think buybacks make the most sense for us. The key I would make is that's true right now. We've always tried to say things can change depending on what's happening and what -- where we see the best place to add value. So it's important that we see both of them being very important. And if we look marginally right now, we see opportunity in our unit price. And as long as we see that opportunity, that's where we're going to focus. But it's not set in stone. That's just where we are right now.”
With not a lot of growth projects on the table, MMP will see most of its growth come from tariffs increases. The company is planning to take an all-in 8% tariff increase on July 1st. According to the company, PPI is projected to have increased 13.5%, so its hikes will be less than that.
In terms of risk, both transport volumes and commodity prices are a risk. MMP projects that a 1% change in volume on its pipeline has about a $10 million impact on its business. Meanwhile, every $10 change in the price of crude has about a $35 million impact. Now there should be some type of natural hedge in there, as lower prices can lead to more driving and gas consumption, and vice versa.
2023 being the first full year without any Covid-related restrictions in the U.S. would seemingly bode well for refined product demand. However, demand so far this year has actually dropped below pre-pandemic levels. Weak demand and lower prices in response to that demand would be a negative for MMP.
Backwardation, when oil futures are lower than current prices, is also a current headwind for MMP's storage business. The company has said this has made it difficult to renew expiring contracts, as such storage revenue will be lower in 2023 versus 2022.
Conclusion
MMP currently trades at 10.6x the 2023 consensus estimate of $1.51 billion and 10.3x the 2024 consensus estimate of $1.56 EBITDA. It has a FCF yield of about 11.6%, and has 3.6x leverage.
Compared to peers, it trades at a nice premium for a low-growth midstream operator. Right now, the company is riding some nice tariff tailwinds, but it’s not something I’d bank on year in and year out. Meanwhile, the company has struggled to find acceptable growth projects, and its share buyback isn’t making a huge dent in reducing its units outstanding.
As such, I’d view MMP more as a “Hold.” The distribution is safe and the conservative nature of the company should give you a nice high-yield bond-like return – and there is certainly nothing wrong with that. The stock currently yields around 7.8%. However, I do think there are better values in the midstream space out there.
Geoffrey Seiler
Former Senior Equity Analyst at $600M long-short hedge fund Raging Capital.
Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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